CHAPEL HILL, N.C. (MarketWatch) — One of the most widely read documents of the investment calendar is scheduled to be released Saturday, Feb. 23.
I’m referring to Warren Buffett’s annual shareholder letter, which is contained in the annual report of his company, Berkshire Hathaway BRK.B, +0.23% (Here’s the 2017 letter for reference.)
Just because his letter is widely read, however, doesn’t mean it is properly understood. What follows are three of the most profound investment takeaways of his soon-to-be released letter, implications that I fear may otherwise be ignored:
Eventual retirement
All eyes will be on whether Buffett, now 88, gives any indication of when he may retire. The presumption is that, absent Buffett, we lose all hope of duplicating in the future his outstanding past performance.
Brett Arends: ‘If you can’t beat the market, how did Warren Buffett do it?’
That presumption is false. It’s been more than five years, in fact, since researchers discovered a stock-picking formula that, mechanically applied, could have replicated Berkshire Hathaway’s returns over the past five decades. That means we now have more than five years of real-time performance of this formula, and it has passed the test.
The researchers’ formula emphasizes “cheap, safe, quality stocks,” by which they mean those with below-average volatility, low price-to-book ratios, and are of companies whose profits are growing at an above-average pace and that pay out a significant portion of their earnings as dividends. A full description of the formula is available in an article they wrote last year for the Financial Analysts Journal.
The mutual fund that perhaps come closest to putting the researchers’ formula into practice is the AQR Large-Cap Defensive Style Fund AUEIX, +0.24% (That’s hardly a surprise, since they all work with AQR.) Over the five calendar years through the end of 2018, this fund beat the growth in Berkshire’s net asset value (NAV) by an annualized margin of 11% to 9.9%. (For Berkshire Hathaway’s 2018 NAV growth, I relied on the FactSet consensus.)
Unfortunately, this AQR fund has a high investment minimum of $1 million. But you may be able to invest a smaller amount in the fund through your financial adviser.
Size matters
This is a subject to which Buffett has at least alluded in past shareholder letters, when he has acknowledged that the sheer size of Berkshire Hathaway’s portfolio means that it’s harder for him to find the truly undervalued great businesses in which he likes to invest. With that acknowledgment, Buffett is saying that performance is unlikely to be as good as it was in the past.
He’s right, of course. His performance in more recent years is not nearly as far ahead of the market as it was earlier in his career. As you can see from the accompanying graph at the top of this article, Buffett’s lead over the dividend-adjusted S&P 500 Index over his entire tenure at Berkshire Hathaway is 9.1 annualized percentage points. His alpha declines as we focus on progressively shorter periods, and over the past 10 years it’s actually negative.
From this perspective, we might expect to do even better following the researchers’ formula ourselves rather than investing in Berkshire stock, since alternate portfolios will be a lot smaller. The AQR Large-Cap Defensive Style Fund AUEIX, +0.24% for example, has $2.7 billion in assets currently, in contrast to a Berkshire Hathaway market cap in excess of $500 billion.
Let’s get real
Yet another important investment lesson that you will be able to draw from Buffett’s latest shareholder letter: Annualized returns in the high teens is the upper limit on what we can realistically expect from our portfolios over the long term.
Think about it this way: If Buffett, widely considered to be the most successful investor alive today, has produced an annualized return over the past 54 years of “only” 18.8%, what makes you think you can do better?
I put “only” in quotation marks because 18.8% annualized is more than enough to produce riches beyond the dreams of avarice. But, judging from some of the more colorful and outlandish advertisements from unscrupulous advisers, returns many orders of magnitude greater than that are easily attainable — if you just sign up now for their service.
It’s, of course, theoretically possible that the next Warren Buffett is selling his advice on the internet for $39.95 a month. But if you believe that, then I definitely have a bridge to sell you, along with some great lake-front property that sits atop huge oil reserves.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email mark@hulbertratings.com.
